IRS legal advice requires capitalization of ANDA costs

Pharmaceutical companies incur costs at various stages before marketing their product, including investigation costs, FDA filing fees, and legal fees. To market, a generic version of an already approved drug, the maker of that generic drug must submit an abbreviated new drug application (ANDA) to the FDA. It’s no secret pharmaceutical companies are faced with immense patent litigation costs, as the filing of an ANDA is considered a technical act of infringement under the Patents Act. The Act requires the patentee pioneer drug manufacturer to file suit within a prescribed number of days of the ANDA filing. The treatment of these expenses, whether deductible or capitalized, is the subject of many IRS examinations. A piece of recent legal advice issued by field attorneys (LAFA) issued by the IRS outlines the facts and circumstances considered when ruling on the proper treatment of similar expenses incurred by a pharmaceutical company.

Background

The IRS concluded in LAFA 20114901F¹ and reaffirmed in AM 2014-006², that FDA abbreviated new drug applications (ANDAs) are franchises, the costs of which are capitalizable under section 263(a)³ and amortizable under section 197. Moreover, when the taxpayer that files the ANDA settles a patent infringement lawsuit based on the ANDA application, the fees incurred to defend the suit should be capitalized subject to section 263A, rather than deducted as ordinary business expenses under section 162. AM 2014-006 also discussed the treatment of expenditures from the taxpayer that claims the ANDA violates their patent. In that situation, the taxpayer generally has an ordinary necessary expense under section 162.

Discussion

In LAFA 20114901F, the taxpayer, Corporation X, incurred legal fees to defend against a patent infringement lawsuit after it filed ANDAs with the Food and Drug Administration (FDA). The ANDA would have allowed the taxpayer to market and sell its generic versions of certain patented drugs. The taxpayer settled the lawsuit and, as part of the settlement, received licenses to market and sell the generic drugs. On its federal income tax returns, Corporation X asserted that all litigation fees were deductible as ordinary business expenditures under section 162. It stated that section 1.263(a)-4(d)(9) did not apply since Corporation X “did not hold, nor was it seeking title to any intangible as part of the litigation process." The taxpayer also claimed that related fees it incurred for investigating the patents should be deducted.

The IRS disagreed and found that both types of fees must be capitalized. The IRS used a two‑step analysis to come to this conclusion. First, it applied the origin of the claim test and found that the infringement litigation originated from the corporation's actions to obtain assets for sale or use in its trade or business; therefore, the claims were capital in nature. Second, it analyzed whether the legal fees were within the scope of section 1.263(a)-4, which identifies categories of intangibles that must be capitalized. These categories include amounts to acquire, create, or enhance an intangible. In considering these regulations, the IRS concluded that:

1. As franchises, FDA-approved ANDAs are section 197 intangibles that are amortizable rateably over a 15-year period beginning on the first day of the month the FDA-approved ANDA is acquired, provided all applicable exclusionary periods have expired and provided that the trade or business requirement of section 197 is met.  Section 197 prohibits amortizable section 197 intangibles from being depreciated or amortized under any other provision. Thus, the ANDA-based settlement rights cannot be deducted under section 162.
2. Alternately, as government-granted rights within section 1.263(a)-4(d)(5)(i), rights granted pursuant to ANDAs are licenses or other similar government-granted rights within the meaning of section 197(d)(1)(D), with the cost recovery method the same as for franchises.
3. When ANDA infringement litigation settlements result in the plaintiffs granting the ANDA holders licenses to market and sell the drugs the subject of the ANDAs, the fees incurred to investigate the patents and to defend against the infringement suits should be capitalized to the basis of the licenses and suspended until the licenses are amortizable or depreciable. If the licenses are for the use of section 197 intangibles, the legal fees would be recovered pursuant to section 197.
4. Once the taxpayer begins production of the drugs for commercial release, the annual cost recovery of the legal fees capitalized to ANDAs and licenses are subject to capitalization under section 263A.

This guidance was followed by a memorandum that was issued to the same Technical Advisor on Sept. 27, 2011⁴ that illustrated why ANDAs are within the nonexclusive list of types of government-granted rights in section 1.263(a)-4(d)(5)(i) and are considered to be government granted franchises. It noted that while the -4(d) regulations addressing created intangibles do not define the term “franchise,” the term is defined within the capitalization of intangible regulations addressing acquired intangibles. Under section 1.263(a)‑4(c)(1)(viii), “franchise” for purpose of acquired intangibles has the same meaning the term is given in section 1.197-2(b)(10). Section 1.197-2(b)(10) states that a “franchise has the meaning given in section 1253(b)(1) and includes any agreement that provides one of the parties to the agreement with the right to distribute, sell, or provide goods, services, or facilities, within a specified area.” 1253(b)(1) defines a franchise to include an “agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area." Sept. 27, 2011, Memorandum stated that Corporation X’s ANDAs fit neatly into the sec. 1253(b)(1) definition since the ANDAs gives Corporation X the right to market and sell its ANDA products within the United States, a territory that encompasses the entire country. Further, on Sept. 27, 2011, Memorandum pointed out that courts have noted that Congress provided an "expansive definition" of the franchise to “include” agreements to sell or distribute goods within a specified area, which does not exclude other things otherwise within the meaning of a franchise.⁵ Additionally, on Sept. 27, 2011, Memorandum noted that according to T.D. 9107, the identified categories of expenditures that must be capitalized under section 1.263(a)-4 are construed broadly.

Both the current guidance and the September 27, 2011 memorandum followed guidance issued on Jan.  1, 2001, that determined that ANDA-related costs are potentially deductible under  174.⁶ The Jan.  1, 2001 guidance stated that generic drugs, like all other new drugs, must be approved by the FDA. Generally, new drug products are approved on the basis of a "new drug application" while generic drugs are approved by with ANDAs. According to the Jan.  1, 2001 guidance, the significant difference between an ANDA and a new drug application (NDA) is that the NDA must contain data demonstrating the safety of the new drug and substantial evidence establishing the effectiveness of the new drug for its intended use. In contrast, the information contained in an ANDA must show that the active ingredient, the route of administration, the dosage form, the strength, and the conditions of use recommended in the labeling of the generic drug are the same as the listed drug on which the generic is based. The guidance then stated that under section 1.41-4(a)(3), which has since been repealed, "[f]or purposes of  41(d) and this, research is undertaken for the purpose of discovering information only if it is undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering." The guidance held that taxpayers who develop generic drugs may be able to satisfy the discovery test and avoid the duplication exclusion under section 41(d)(4) when undertaking research directed toward the development of a generic drug. Since the discovery test has been repealed and replaced by more lenient regulations, it is easier for a taxpayer to qualify for ANDA-related activities as section 174 expenses provided that the costs meet all of the other requirements.

In addressing taxpayers who asserted a claim against ANDA applicants, AM 2014-006 generally concluded that those expenditures are currently deductible under section 162. In the case of a drug manufacturer that holds a patent on a drug for which an ANDA with IV certification is filed, the legal fees incurred by the drug manufacturer to try to establish that the manufacture, use, or sale of the drug is subject to the ANDA would infringe the drug manufacturer's patent are incurred to defend an existing intellectual property right, and not as part of the creation of a new intangible. However in the context of a patent infringement suit arising from an ANDA with IV certification for the ownership or title to the patent to be in question, then Treas. Reg. section 1.263(a)-4(d)(9) may require capitalization of some portion of the drug manufacturer's legal fees.

Insights

The guidance provides clear guidance on the IRS’s position about the deductibility of legal fees incurred in the process of obtaining abbreviated new drug applications. For clients that are considering applying for such licenses to produce generic drugs, tax professionals should determine whether any costs incurred to prepare and obtain the ANDA, as well as the costs of any related patent litigation, should be capitalized and recovered appropriately (e.g., amortized under section 197 or as an inventoriable cost under section 263A), depending on the facts and circumstances. For clients that have brought actions against ANDA filers, those expenditures may be currently deductible. It will also be essential to determine whether a change in method of accounting will be necessary for clients that have incurred these types of costs in the past who may not have treated them in accordance with the guidance.

^{_{1. Sept. 14, 2011.}}

^{_{2. Sept. 12, 2014.}}

^{_{3. See section 1.263(a)-4(d)(5)(i).}}

^{_{4. See LAFA 20114703F (Sept. 27, 2011).}}

^{_{5. Citing Jefferson-Pilot Corp. v. Commissioner, 98 T.C. 435, 443 (1992), aff'd, 995 F.2d 530 (4th Cir. 1993) (FCC licenses are agreements “between the Federal Government and the licensee, under which the licensee agrees to provide the service of radio broadcasting within a specified area in exchange for the right to broadcast”); Jefferson-Pilot Corp. v. Commissioner, 995 F. 2d 530 at 531 (4th Cir. 1993) (“The definition of term ‘franchise’ is sufficiently broad to include licenses issued by the FCC.”).}}

^{_{6. See “LMSB Directive on the Planning & Examination of Research Credit – Generic Drugs” (Jan. 1, 2001).}}